Tuesday, October 6, 2009

Note: I am not an investment advisor and nothing I state should be taken as investment advice. Please consult your own private professional financial advisor for help in making investment decisions.

A few days ago I posted about Brazil's economic rise. I wrote that the awarding of the 2016 Summer Olympics to Rio de Janeiro (as well as the fact that Brazil is hosting the 2014 FIFA World Cup) was further good news for an already strong, developing economy.

The gist is that the Gulf states, China, Russia, Japan and France plan to stop using the U.S. Dollar for oil transactions beginning in 2018. The dollar will be replaced by a basket of currencies that will include the Japanese yen, the Chinese yuan, the euro, gold and a new unified currency that will be introduced for all the Gulf Arab states. Brazil and India have shown interest in participating in such a transition.

This transformation will be a pretty big blow against the value and supremacy of the U.S. Dollar.

I subtitled this post "Good news for gold" because the article also states:

The transitional currency in the move away from dollars, according to Chinese banking sources, may well be gold. An indication of the huge amounts involved can be gained from the wealth of Abu Dhabi, Saudi Arabia, Kuwait and Qatar who together hold an estimated $2.1 trillion in dollar reserves.

That means significantly greater demand for gold may be on the horizon. If these "Chinese banking sources" are right. How far on the horizon is an entirely different question. Keep in mind that this transformation isn't likely to take full effect before 2018. If this article is trying to imply that these participating states will buy their gold with dollars, that will only serve to weaken the dollar further and push up the value of gold even more.

I also subtitled this post 'Ron Paul was right.' First of all, Ron Paul is a huge gold bull so there's that. More importantly, Ron Paul has publicly spoken about the oil-dollar relationship for a long time and he warned us that something like this was unavoidable quite a while ago.

Realizing the world was embarking on something new and mind-boggling, elite money managers, with especially strong support from U.S. authorities, struck an agreement with OPEC to price oil in U.S. dollars exclusively for all worldwide transactions. This gave the dollar a special place among world currencies and in essence “backed” the dollar with oil. In return, the U.S. promised to protect the various oil-rich kingdoms in the Persian Gulf against threat of invasion or domestic coup. This arrangement helped ignite the radical Islamic movement among those who resented our influence in the region. The arrangement gave the dollar artificial strength, with tremendous financial benefits for the United States. It allowed us to export our monetary inflation by buying oil and other goods at a great discount as dollar influence flourished.

This post-Bretton Woods system was much more fragile than the system that existed between 1945 and 1971. Though the dollar/oil arrangement was helpful, it was not nearly as stable as the pseudo–gold standard under Bretton Woods. It certainly was less stable than the gold standard of the late 19th century.

During the 1970s the dollar nearly collapsed, as oil prices surged and gold skyrocketed to $800 an ounce. By 1979 interest rates of 21% were required to rescue the system. The pressure on the dollar in the 1970s, in spite of the benefits accrued to it, reflected reckless budget deficits and monetary inflation during the 1960s. The markets were not fooled by LBJ’s claim that we could afford both “guns and butter.”

Harrison tries to explain the historical roots of our current economic crisis. Harrison challenges conventional thinking and argues that the U.S.'s economic policy of the 1950s-1970s was not really Keynesian, just as our economic policy during the 1980s-2000s was not really free-market. Instead, he tries to take an apolitical perspective and he argues that excessive debt is the root source of the current crisis. The economy's structural problems were masked by "the financialization of the American and British economies." By this he is referring to the growth of the financial sector and the reliance on a series of economic bubbles, inflation and (artificial) asset price appreciation for economic growth. The housing crisis and resulting financial crisis finally forced the economy's structural problems to the fore.

There is nothing terribly new here. Other writers have hit on these points before but Mr. Harrison brings it all together in a very eloquent and well-sourced narrative.

Here is Harrison's summary of the historical events that led to our current situation, in his own words:

1. A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.

2. The effects of this depression have been lessened by economic stimulus and government support.

3. Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.

4. In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized.

5.Because large scale government deficit spending is politically impossible, expect a second economic dip within three to four years at the latest.

What does Harrison think of the U.S. government's response to the crisis? He states that all of its efforts essentially boil down to a desperate attempt at increasing asset prices, or at least preventing them from declining further. This is true of the TALF program, the TARP program, the proposed elimination of marking-to-market accounting, near zero interest rates and the Capital Assistance Program. The government is basically trying (and somewhat succeeding at) "reflating" the economy.

In the longer term, Harrison believes that there are only two things that can prevent the American economy from experiencing a significant contraction: (1) prolonged, large-scale government deficit spending to replace contracting private consumption, or (2) transforming the American economy so that it can run a trade surplus. Option #2 is basically impossible to achieve, he argues. Option #1 is politically impossible in the long-term. When that government spending thats propping up the economy ends, expect a serious economic contraction more severe than the first (which will finally convince policy makers and the public that we're in a depression).

Edward Harrison's analysis is without a doubt one of the best I've read in a long time. I seriously encourage you all to go read it in full. However, I have a few questions/comments I would make to Harrison.

1. Harrison doesn't address the possibility that excessive government spending could weaken the U.S. Dollar to the point where its status as the world's reserve currency could be seriously challenged. What does he make of China, Russia and other emerging economies talking about replacing the Dollar for reserve currency purposes? What does he make of Tiger Management's Julian Robertson warning about the Dollar's future? What does he make of the World Bank's president's recent comments? On his biography page it states that Edward Harrison was a diplomat earlier in his career, therefore his insight would be particularly valuable. Is this all just political posturing or is it a serious challenge?

2. I want to focus on one point Harrison makes: he comments on the "financialization" of the American economy. This is a reference to the fact that economic growth in the U.S. (and U.K.) has been very reliant on the manipulations of (and growth of) the financial sector. I think this point deserves deeper examination. As I see it, not only is this not a normal recession, its not a "normal" depression in the sense that our economy is radically different from the way it was in the 1930s. Lets say government spending propped up the economy for an extended period during which much of the private sector's debt could be unwound and paid off, where would growth come from after that period ended? What sector(s) of the economy would be able to sustain the American standard of living after that period ends? Does he expect sectors like construction and retail to come back in full force? Judging from his economic analysis of the years 2000-2006, I doubt it. Does he expect much of the financial sector to be repurposed? And if so, to what ends? Even if most private sector debt is unwound during a prolonged decade-long period of Keynesian support of the economy and slow but steady economic growth returns after that, isn't it true that we would still need a return to trade surplus conditions in order to pay off our public debt which would, by then, probably be massive?

3. Harrison remarks that the U.S. is following the deflationary, secular bear-market model that Japan experienced during the "lost decade(s)." He should explain to laymen such as myself why, after two decades of economic stimulus and propping up the economy through deficit spending and efforts at preventing asset price declines, Japan was still unable to prevent long-term economic contraction and bear-market conditions. What did it do wrong and what is the U.S. doing right or differently which would allow us to succeed? Remember, Japan is still experiencing historic year-over-year deflationary declines as of last month.

4. Harrison comments that we can expect "an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government" over the next decade as a result of the coming economic volatility/instability. An extremely important point, I think. Nice euphemism by the way ... "more muscular." What are Mr. Harrison's thoughts on cutting military spending and government spending in order to lessen the possibility that desperate and bankrupt governments will turn to war and authoritarianism as a solution to their problems? I'm leaning towards it being a good idea, at least if we can convince the rest of the world (by which I mean, the other big military spending countries besides the U.S.) to go along with it as well. Unfortunately I don't see any politicians from the two major parties who have the political will or foresight to press for something like that on the global stage. I'd be particularly interested in Mr. Harrison's thoughts on this matter since he is a former diplomat.

I really, REALLY encourage you to go read the article. Most of the rest of the financial media is still standing amazed at the fact that Wall Street firms are still up to their usual "tricks" (massive derivatives trading, over-leveraged banks, "flash trading," etc). Duh. Did anyone really expect that to change? I expect more from my readers. This article is far more forward-thinking, paints a far broader picture and is much better sourced than most of the junk that the mainstream media is printing.

Saturday, October 3, 2009

Note: I am not an investment advisor and nothing I state should be taken as investment advice. Please consult your own private professional financial advisor for help in making investment decisions.

The big news yesterday was that the 2016 Summer Olympics were awarded to the city of Rio de Janeiro. I say good for Rio, congratulations!

A lot of the media coverage around this story in the U.S. focused on President Obama's trip to Copenhagen to lobby the International Olympic Committee on behalf of the city of Chicago's Olympic bid. Clearly those efforts failed.

However, I was more interested in another angle: how this announcement relates to the Brazilian economy.

The 2014 FIFA World Cup is also being held in Brazil. The FIFA World Cup actually garners more television viewers around the globe than the Summer Olympics does. Unlike the Summer Olympics, which will take place almost entirely within Rio de Janeiro, the World Cup will be staged in twelve host cities across the country.

So two of the biggest atheletic competitions in the world (possible, the two biggest atheletic competitions in the world) will both be held in Brazil within 2 years of each other. This is great news for the Brazilian economy. Construction will create jobs. Brazil will likely see a multitude of tourists and foreign media visit its country and spend. Brazil will be forced to expand and build up its infrastructure. The economic "multiplier effect" of this infracture spending will likely be considerably greater than it would have been in Chicago, Tokyo or Madrid where infrastructure is already considerably built out and already of a relatively high quality.

The government of Brazil is planning on investing $11 billion into the economy as host. Some analysts have commented that Brazilian commodity producers stand to gain from the massive infrastructure construction. [1]

Reuters India is reporting that a Brazilian government-commissioned study is estimating that the Olympics alone will give the Brazilian-economy a $24.5 billion boost. Furthermore, a U.C. Berkeley study has found that countries that host the Olympics generally have a subsequent growth in exports. [2]

The news goes beyond athletics and international spectacles however.

Just yesterday, the Los Angeles Times reported that Brazil "is leading Latin American nations out of recession." It will have flat to slight growth this year and is projected to grow at a rate of 3.5% in 2010. Compared to another large, industrial Latin American country, Mexico, the differences are stark. The IMF is projecting that Mexico will contract an alarming 7% this year before growing 3% next year. [3]

Of course, these projections are based on the premise that Latin America is indeed going to enter a recovery phase next year. Thats not a given, although it seems more likely than the possibility that the United States will enter recovery next year, in my opinion. Regardless, its clear that Brazil seems to be out-competing many other Latin American countries and is emerging as a strong and dynamic economy in the region.

The Wall Street Journal is painting an even rosier picture. Its reporting economic growth of 1% in 2009, with projected growth of 4.5% to 5% for 2010. However, economists also warn about the dangers of inflation and higher interest rates (despite interest rates being at a historic low at the moment). [4]

I don't mean to sound like a rah-rah cheerleader for Brazil (really!). Brazil still faces major obstacles. The image most Americans have of Brazil is of violent slums, as depicted in the movie 'City of God.' Violent crime is a major issue facing the country. Much of the country lives in poverty and, of those, many are down-right destitute. As is the case in most Third World countries, political and civic corruption is endemic. It has a history of political instability. The list of problems that Brazil faces could go on and on.

However, I think theres some substance to all of the positive reports coming out about Brazil. Normally, when Americans think of large, industrial, developing economies we think of China. However, the Chinese economy is deeply intertwined with the troubled American economy and faces significant structural problems of its own. If you look at my post from yesterday on a possible stock market crash, you'll see that some analysts believe that there is a Chinese commodities bubble. Brazil has many of the positive aspects of an economy like the Chinese one but seems to be a bit less exposed to the type of risks that China faces. Thats my (uneducated) opinion at least, so take it as you will. At the very least, its an economy to keep your eye on.

Of course, who can forget Brazil's two most important assets (nay, national treasures): beautiful Brazilian women and beautiful Brazilian beaches. :)

The question I posed was: Do you support healthcare reform in the U.S.?

The results were:

1. Yes, I support instituting a universal healthcare system: 3 votes (3%)2. Yes, with a public option: 8 votes (8%)3. Yes, but without a public option: 5 votes (5%)4. No, not at all. It would cost too much: 3 votes (3%)5. No, not at all. The government is too inefficient: 15 votes (16%)6. No, not at all. I don't trust President Obama: 14 votes (15%)7. No, not at all. I don't trust government, period: 43 votes (47%)8. Undecided: 0 votes (o%)9. Other: 0 votes (0%)

91 people voted in total.

According to my own calculations, that means 16 votes (17.6%) were in favor of healthcare reform in some form and 75 votes (82.4%) were against it.

I was surprised to see that not that many people were against healthcare reform because of financial or cost-related issues. Most were against it because they didn't trust the government and/or President Obama or because they thought the government would be too inefficient in administering healthcare.

What are his ten reasons? Well, I encourage you to go over to SeekingAlpha and read the article for yourself but I'll give you a taste here. In my own words, his ten reasons are:

1. Rampant insider selling.

2. Much of the current rally has been (a.) based on trading in bankrupt companies (Fannie Mae, Freddie Mac, Lehman Brothers, etc) (b.) made up of investors trying to cover their shorts and (c.) of a low volume.

3. Most investors are short-term bullish and long-term bearish. Furthermore, market psychology does not currently correlate with the economic fundamentals.

4. A lot of the market is short on the U.S. Dollar and long on ... "everything else."

5. Household incomes are going down while the number of people living in poverty is growing. "Income dispersion" is growing.

6. There is a Chinese commodities bubble. The rise in commodities prices isn't because the Chinese economy is really growing as fast as it appears to be, its the result of the Chinese investing in commodities so as to avoid the U.S. Dollar. The Chinese business model is just as flawed as the American one.

7. Under President Obama we have more government intervention into the economy, there is increased protectionist sentiment and there are "socialist tones" to our political rhetoric.

8. The money supply and credit continue to contract at alarming rates.

9. The market is very complacent and everyone is (falsely) assuming that everything is okay.

10. The European economy is still in shambles despite proclamations from European political leaders that "the recession is over" there. To quote Baggio:"What happened to Latvia’s currency crisis or the Swedish Banks? Are Hungary and Poland ok? Has the Austrian Banks’ exposure to Eastern Europe disappeared? Is Spain back on its feet? Is the UK solvent again? Are Irish banks lending like there is no tomorrow? How about Germany’s manufacturing base—is it solid with a EUR at 1.48 and the US consumer missing-in-action? Is Deutsche Bank’s $3 trillion balance sheet made up of only physical Gold? Are German banks profitable and healthy again? I guess somebody waved a magic wand and fixed all Europe’s problems overnight!"

This is just a very basic summary of Mr. Baggio's article. This summary doesn't do it justice so I encourage you to go over to the actual article and read it in-depthly.

So there you have it. Are you convinced? What are your thoughts on the future of the stock market?